Stupid Investment of the Week

Commentary: Oregon dials wrong number with 529 college-savings option

BOSTON (MarketWatch) -- Call it a "chopped sirloin," and serve it with "a fluffy mix of egg yolks and oil and a puree of ripe tomatoes, spices and sugar," but once you cut through the hype you're left with a hamburger, topped with mayo and ketchup.

A lot of investments are dressed up and sold in the same fashion, a clever way to get someone to pay a little more for a product that, in the final analysis, is a little less.

Promise a guarantee of "no losses," wrapped in the potential for "participating in any stock market gains" and you can come up with a product like the "Education CD Plus Investment Option" in the state of Oregon's 529 Savings Plan, an investment idea that calls for the question "Where's the beef?" and which is deserving of being the Stupid Investment of the Week.

Stupid Investment of the Week highlights the concerns and characteristics that make an investment less than ideal for the average consumer, and is written in the hope that highlighting the traps and troubles in one case will make problems easier to root out elsewhere. While obviously not a purchase recommendation, this column is not intended as an automatic sell signal, as dumping problem investments sometimes leads to double trouble.

Failing grade

In the case of the Education CD Plus, a frustrated investor might simply look at other options within the same plan, which is run by OppenheimerFunds, but they lose the guarantee against losses if they make that move within five years. Since the Education CD Plus only became available last fall, that would be a necessary sacrifice for anyone looking to move into the state program's eight other, superior investment alternatives.

There are several different types of college-savings plan, many falling under the rubric of "529 plan" for the section of the law that makes them possible. Tax advantages can vary by state and plan -- and many states, including Oregon, have several different plans run by assorted money-management firms -- but the idea is to have a safe haven to grow money, tax-deferred for college tuition.

The Education CD pays investors 80% of the average five-year gain in the Standard & Poor's 500 Index
SPX, -1.66%
with a minimum return of zero. If the market tanks, you get back your initial investment principal, minus a sales charge of 4.75%. In a good market, you get 80% of the market's return, but not any dividends paid out by companies in the S&P 500.

Moreover, the cost structure is brutal. Total asset-based fees amount to 1.15%, which is more than five times what a savvy fund investor is likely to pay for exposure to an S&P 500 index fund. According to the plan's documents, an investor who puts $10,000 into the plan, who holds it for five years to lock in the guarantee, and who winds up making a 5% return -- meaning the guarantee wasn't necessary -- would wind up spending $1,081 in costs. Ouch.

Michael Parker, executive director of the Oregon College Savings Network, says the product is all about the no-loss guarantee. "The board struggled with trying to find some sort of product that was guaranteed," he said. "That's the main driver here, to have a guaranteed, principal-protected option."

No guarantee

The problem is that the guarantee is almost certainly not necessary, particularly at the cost.

For proof, consider a simple alternative strategy, namely that you put 80% of your investment into an S&P 500 index fund and 20% into a money-market fund.

An investment consultant friend of mine -- he asked not to be named, but he has never worked in the 529 plan business and has no ties to any companies in the field -- calculated that the 80-20 strategy would have topped the index-linked CD in 394 of 395 overlapping five-year rolling time periods dating back to 1975.

Further, in roughly 95% of those time periods, the S&P 500 had positive returns; even when the index was down, the cash returns from the money fund made the 80-20 strategy come out ahead virtually every time.

In short, you're paying high costs -- and suffering significant shortfalls in returns -- to get a guarantee that history suggests will be the best solution less than 2% of the time.

Oregon's plan is not the only equity-linked 529 plan out there, although some other attempts to do this have failed. It's still early to determine if the program is picking up traction, according to Parker, who agreed that it's distinctly not the investment for "a broad spectrum of people, but rather for those who really want a guarantee that they will not lost their principal."

Joseph Hurley, who runs SavingforCollege.com, is a bit more blunt, saying these kinds of investments are "for nervous investors only. ... And history shows us that people who invest like they are scared, right when the market is making them nervous, tend not to make the best investment decisions."

Investors who sour on the program can forego the guarantee and remove their money without paying a penalty. That could happen when they find out that they're paying for chopped sirloin, but eating ordinary hamburger.

"It's all smoke and mirrors to get nothing," said Philip Johnson, a Clifton Park, N.Y. adviser who specializes in college planning.

"Why have a complicated program like this when you can do the same thing a whole lot easier on your own and be likely to get better gains?" he added. "If the fear of investment losses is driving your decisions so much that you'd actually buy this, you'd be better off just putting the money into an ordinary certificate of deposit and taking a guaranteed return. You'll sleep better, and you won't be overpaying for something that's not going to live up to your expectations."

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